by T. GormanPosted on Posted in SECActions

The split among the circuits over how to plead scienter, coupled with the legislative hearings which detailed abuses in bringing private securities damage actions, spawned the requirement to plead a “strong inference” of scienter incorporated in Section 21D(b)(2) of the Reform Act. During the legislative hearings, Congress heard repeated testimony about the filing of suits which were lawyer-driven. Those suits, Congress was told, were frequently frivolous and contained few facts. Nevertheless, large settlements often resulted because of the burdens of discovery and the potential liability, rather than the merits of the claim. Based on this testimony, Congress concluded that a “complaint alleging violations of the federal securities laws is easy to craft and can be filed with little or no due diligence.” S. Rep. No. 98, 104th Cong. 1st Sess. 8 (1995). Congress concluded that Fed. R. Civ. P. 9(b) was largely ineffective.

In crafting Section 21D(b)(2), Congress borrowed the standard of “strong inference” from the Second Circuit case law, which was viewed as the highest pleading standard at the time. The purpose was to create a uniform pleading standard. See, e.g., H.R. Conf. Rep. 104-369 at 31, 41. At the same time, Congress chose not to adopt the Second Circuit case law which interpreted the strong inference standard.

As the bill containing what would become Section 21D(b)(2) moved through Congress, Senator Specter offered an amendment. That amendment sought to incorporate the Second Circuit case law into the bill which would become the Reform Act. The amendment was rejected, according to Senator Dodd because it contained an incomplete codification of the Second Circuit case law. 141 Cong. Rec. S 19067 (daily ed. Dec. 21, 1995).

The Joint Conference Committee Report stated that the “strong inference” standard was in fact taken from the Second Circuit case law and that the “particularity” requirements of the Reform Act were keyed to Rule 9(b). The Report went on to note that the bill was intended to strengthen pleading requirements. Accordingly, “it does not intend to codify Second Circuit’s case law interpreting [the] standard.” H.R. Conf. Rep. 104-369 at 41. The Report notes, however, that “courts may find this [the second circuit] body of law instructive.” Id. at 15.

Subsequently, President Clinton vetoed the bill, arguing that the standard exceeded that of the Second Circuit. At the same time, President Clinton made it clear that he would support a bill containing the Second Circuit standard. Congress overrode the veto. During the floor debates, supporters of the bill noted that it incorporated the Second Circuit standard. See, e.g., 141 Cong. Rec. S 1906 7 (daily ed. Dec. 21, 1995).

From this history, Section 21D(b)(2) of the Reform Act emerged, requiring that a securities fraud plaintiff plead a “strong inference” of the “required state of mind.” The undefined phrases in the section and the Section’s complex and at times seemingly contradictory history resulted in yet another split among the circuits over the proper pleading standards. That split ultimately resulted in the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. 127 S. Ct. 2499 (2007).

Next: The circuits split over the meaning of “strong inference” and the “required state of mind.”

 

by T. GormanPosted on Posted in SECActions

The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. 127 S. Ct. 2499 (2007) regarding Section 21D(b)(2) of the Reform Act is rooted in a split in the circuits over the pleading standards for the state of mind in securities fraud suits.  Prior to the Reform Act of 1995, Fed. R. Civ. P. 9(b) required that “fraud or mistake … shall be stated with particularity.  Malice, intent, knowledge, and other considerations of mind of a person may be averred generally.” 

The courts had no difficulty concluding that fraud had to be pled with “particularity.”  Under this standard, facts supporting the “who, what, when and where” of the allegation had to be included in the complaint. 

The courts had no difficulty in agreeing on what constitutes the required state of mind in a Section 10(b) claim.  Under the Supreme Court’s decision in Ernst & Ernst, 425 U.S. 185 (1976), a Section 10(b) claim required proof of scienter.  Although the Court reserved decision on the question of whether scienter included recklessness, the circuit courts quickly and uniformly answered the question in the affirmative. 

The circuit courts could not, however, agree on the requirements for pleading scienter, despite the plain language of Rule 9(b).  Indeed, a three way split developed.  The Second Circuit developed what became known as the strictest pleading standard, requiring a securities law plaintiff to plead a “strong inference” of scienter.  This standard could be met by demonstrating either a motive and opportunity to commit fraud or pleading facts constituting circumstantial evidence of either reckless or conscious behavior.  See, e.g., In Re Time Warner Sec. Litig., 9 F.3d 259 (2nd Cir. 1993). 

In contrast, the Ninth Circuit adopted the most liberal standard.  In In Re GlenFed Sec. Litig., 42, F.3d 1541 (9th Cir. 1994), the court concluded that under Rule 9(b), only notice pleading was required for scienter.  Under this test, only a general allegation was required.

Finally, several courts developed what was essentially a middle view.  In cases such as In Re HealthCare Compare Corp. Sec. Litig., 75 F.3d 276 (7th Cir. 1996), the courts required a plaintiff to plead facts demonstrating a basis for a claim of scienter. 

This split in the circuits over what was required to plead scienter became the key backdrop to Congress’ struggle in 1995 to craft pleading standards which would eliminate frivolous suits while permitting those with merit to proceed. 

Next, the passage of the 1995 Reform Act.